In 2014, we experimented with a simple high probability iron condor trading strategy. We sold far OTM credit spreads which gave us wide profit zone and a high probability of profit. This trading strategy had a great winning percentage – 11 out of 12 of our trades were winners but the loss from the 1 losing trade was so big it wiped out most of our profits for the year! Large losses can be very damaging psychologically especially for inexperienced traders. We concluded at the end of 2014 that the trading strategy used would not be suitable for new traders.
In 2015, let’s try to find another type of iron condor strategy which might be more suitable for new traders. Our first objective is to reduce the maximum loss of the trades. In order to reduce the maximum loss, we need to collect more premium from our credit spreads. We can get more premium by selling options which are closer to the money. This year we will try to collect as much premium as we can by selling ATM credit spreads. This type of iron condor is also known as the Iron Butterfly (IB). The risk graph for this trade is shown below:
As you can see from the risk graph, the profit zone is a lot narrower, but the maximum loss is also a lot less compared to our high probability iron condors. Tasty Trade has done some studies on SPY iron butterflies which has shown that this can be a profitable strategy, even though the winning percentage is low compared to iron condors.
Source: Tasty Trade Iron Butterflies video
The SPY IB study also showed that IV Rank and spread width were also important elements in trading iron butterflies successfully. Just like iron condors, iron butterflies are most profitable when Implied Volatility (IV) is high. Hence, we will only place a trade if IV rank is above 25%. Other research has shown that a good spread width for butterflies is at 5% of the underlying’s price. As our underlying is XJO which is trading around 5000, a spread width of 250 points would be roughly equal to 5%. We will use this spread width in our XJO Iron Butterfly model portfolio.
As time decay for ATM options is fastest in the last 30 days before expiry, we do not want to open IB trades too far out in time. For our XJO IB model portfolio, we will sell iron butterflies with 30-45 days to expiry (DTE).
I placed our Jan’15 XJO IB trade on 1 Dec 2014 which is 45 DTE. IV rank was pretty high at 66%. XJO was trading around 5200 at the time so I sold two ATM credit spreads (5200/4950 put spread and a 5200/5450 call spread) and I managed to collect 161 points of credit for this 250 point IB. The maximum profit for 1 contract is $1610 (if XJO expires at 5200) and the maximum loss is only $890 ($2500 – $1610 received).
The expected probability of profit at expiry for this trade is only 36% ((1-161/250)*100) which is pretty low. Ideally we would also like to have a high winning percentage in addition to a low maximum loss as a new trader might be tempted to give up after a few consecutive losing trades. We learned last year that the probability of touch is 2 times the probability of expiry (see my March 2014 post). Hence, the probability of profit should be higher than 36% if we do not wait for the trade to expire. Most experienced traders do not hold butterfly trades to expiry. Instead they set a profit target (e.g. 15-20% of capital at risk) and close the trade once the target is reached. They also set a stop loss to avoid big losses. I came across this book “A Bullsh*t Free Guide to Butterfly Spreads” by Gavin McMaster while doing my research for this model portfolio. There is a great chapter in this book on how to set profit targets and stop losses for butterfly trades, and plenty of in-depth information on how to trade butterfly spreads for those who want to learn more about this strategy.
For our XJO iron butterfly model portfolio, I decided to set a profit target of 10% of spread width, which is the same profit target as our 2014 high probability iron condors. As our spread width is 250 points, our profit target is $250 per contract. We will set our stop loss at $375 which is 1.5 times our profit target. All the above is summarised in our XJO Iron Butterfly Trading Plan which we will use to trade our model portfolio.
Our first trade went very well. We hit our profit target in just over two weeks! I closed the Jan’15 trade on 17 Dec for a profit of $244. It was a good thing we exited the trade early, otherwise the Jan’15 trade would now be sitting in a position of loss as the huge rally in the following few days would have knocked the XJO price outside our profit zone as shown in chart below:
For traders with full-time jobs who may not have time to watch the markets, a good until cancelled limit order can be used to close the trade whenever the profit target is reached. Similarly, a stop loss order could be set up but personally, I am not a big fan of using stop orders. As the maximum loss is not that big, it is probably better to check our position once a day and manually exit the trade once our stop loss target is breached. There is a little bit more work involved in trading the Iron Butterfly strategy as it is not quite “set and forget” like the high probability iron condor strategy that we traded in 2014.
I opened our February trade on 7 Jan 2015 which is 43 DTE. XJO was trading around 5335 at the time so I sold a 5350/5100 put spread and a 5350/5600 call spread. IV rank was 60% and I managed to collect 153 points of credit for this 250 point iron butterfly. Hence the maximum profit for 1 contract is $1530 and the maximum loss is $970 ($2500 – $1530 received). Our breakeven points for this trade are 5197 (5350 – 153) and 5503 (5350 + 153) as shown below:
I will provide a monthly update on this XJO Iron Butterfly portfolio. As this is first time we are trading this strategy, we normally would paper trade but the bid/ask spreads for butterfly spreads are very large and we cannot get filled at mid-prices in a paper trading account. I will trade 1 contract of this IB in my real account and we can extrapolate this when we do a performance summary at the end of the year. We will track our monthly performance in a similar fashion as our first XJO Iron Condor Model Portfolio. The performance so far as at January 2015 is: